Is Commonwealth Bank of Australia really worth $87 a share?

One broker believes they could be.

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Commonwealth Bank of Australia (ASX: CBA) might have slipped below $80 a share, but one broker believes they are worth much more than that.

In fact, they have today revised their target by 5% and now expect shares to reach $87.80. That reflects a 10.5% upside from today’s price tag of $79.47 and suggests there could well be value in the stock (it would also give the bank a market capitalisation of around $143 billion).

So could the bank’s stocks really soar that high?

Performance

There are various reasons why Commonwealth Bank, along with its primary competitors Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ), have soared to record share prices. The bank has been firing on all cylinders and recently reported a record $2.2 billion cash profit for its third-quarter operations.

It is now on target to deliver an annual profit in excess of $8.5 billion for the first time in the company’s history, driven by record low bad debt charges and increased lending activity, thanks to the low interest rate environment. In addition, its bumper dividend yield also played its part in attracting investors left right and centre.

Outlook

With interest rates set to remain at 2.5% for some time yet, Commonwealth Bank could certainly continue to grow earnings, but I expect that will be restricted to the short term. While the bank is currently trading on a P/E ratio of 15.2, its forward P/E ratio (based on the broker’s target price and forecast EPS for 2015) is 15.8. That is well above its 10-year average of roughly 13.2 and indicates the market expects earnings to continue growing strongly.

Instead, I believe the bank’s earnings will come under pressure in the near future. Interest rates will inevitably rise which could lead to reduced activity while also dragging bad debt charges upwards. I also doubt that investors will want to push the share price up that high as it would greatly reduce the bank’s fully franked dividend yield. Already its yield has fallen to just 4.7% – the lowest of any of the big four banks.

The verdict

The bank’s shares could well continue to climb over the coming weeks, or even months. But to say that they will reach the heights of nearly $88 a share seems a little ambitious, not to mention misguiding for investors with a long-term focus. At today’s price, I cannot see Commonwealth Bank of Australia’s shares climbing another 10%+, nor can I see them outperforming the broader S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) in the medium-to-long terms.

Instead, as earnings come under pressure and its yield becomes less and less attractive, I think the share price could actually retreat in the medium-term, making now not a good time to buy.

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